The fragmentation factor

Many, though certainly not all, of the recent higher-profile trading glitches have occurred in the fragmented securities market rather than the more liquidity-centric derivatives venues. Jim Overdahl, representing the Futures Industry Association's Principal Traders Group, talks about why responding to the technological challenges can be different for the derivatives industry than for securities venues.

Jim Overdahl

Describe the main difference between the situation for
securities and for derivatives:

The main difference (for derivatives venues) is you don't have a
linkage system like you have on the securities side within the
National Market System in the United States.

On the derivatives side, liquidity tends to migrate to a single
trading venue and stay there. For example, Eurodollar futures are
traded almost exclusively at the Chicago Mercantile Exchange
whereas if you have a product on the securities side, such as IBM
stock or some type of ETF, it might be traded at multiple venues,
perhaps as many as 50 venues, including exchanges and alternative
trading systems, broker networks, dark pools.

On the securities side, the number of venues trading a single
product adds to the complexity of trading.

In the derivatives world, related products are also linked. For
example, the S&P 500 futures contract is going to be very
closely tied to the stocks within the S&P 500 or to an
S&P-linked ETF that's traded on a securities exchange, but by
and large, on the futures side, you see trading volume and
liquidity migrate to the single trading venue.

The main thing is that regulation has promoted a fragmented
market structure on the securities side through deliberate policy
choices to encourage competition between trading venues. I think,
in some ways, if you looked at securities markets like options
markets pre-NMS, they behaved very much the same way as
derivatives trading venues behave today. And really what you're
seeing is the network effect of concentrated trading, that is: a
crowd attracts crowd.

Trading on the derivatives side resembles a natural monopoly in
that trading costs become lower when more people participate in
trading on a single trading venue. There have been instances
through time where you saw contracts migrate from one trading
venue to another. One example that people point to is the German
Bund futures contracts that went from LIFFE to Deutsche
Börse. However, these instances are so rare that they are
noteworthy when they occur. The economics of moving liquidity
requires that trading volume increase to a tipping point in order
to attract additional trading volume.

That is why new product development is so important in the
derivatives world - to try and be the first to attract liquidity
and then have the network effects work to the exchange's
advantage when launching a new contract.

On the question of how the dichotomy between the more
complex, fragmented securities side and the more
liquidity-centric derivatives side affects exchange
performance:

A lot of exchanges, depending on their bandwidth, will define how
many trades you have to do per number of orders submitted. It may
be a fixed number like, say, 100 orders per trade. And they do
that, first, to protect their bandwidth. Second, they're
encouraging good quoting behaviour, that is, quoting behaviour
that adds to market quality, while discouraging quoting behaviour
that potentially detracts from market quality. On the futures
side, where a single venue hosts the trading of a product, the
exchange can say, 'Okay, here's our policy: 100 quotes per
trade'. And other exchanges can do the same. In the securities
world, establishing such a rule is harder because it has to be
coordinated across different trading venues. A single exchange
probably couldn't unilaterally come out with an order-to-trade
ratio that would really mean anything, because of it being a
National Market System.

As an aside to this, we see competition between the venues in
setting rules. The Chicago Mercantile Exchange, for example, sets
limits on orders-to-trade ratios and then it will revise those
ratios depending on how their bandwidth changes over time. The
InterContinental Exchange has taken a different approach. It
tries to reward good quoting behaviour and discourage behaviour
that they don't think is adding to market quality. That's one
example where this competition plays out, which is really related
to technology (in terms of bandwidth) and promoting market
quality.

Another example where you'll see differences between the
securities side and the futures side, and this played out after
the Flash Crash, is with error trade policies.

On the futures side, an exchange can set its policy and that's
that. On the securities side, when individual venues have done
this in the past they've had their own policies, but we saw
during the Flash Crash that this led to a lot of confusion
because traders weren't sure of which rules applied across
different trading venues and whether their trades were going to
stand or not stand. And if you're a market maker, carefully
trying to manage your capital and market making risk, it's really
an unacceptable risk to not know whether one side of your hedge
is going to be cancelled later and leave you exposed.

One of the things that the SEC did as a regulatory response to
the Flash Crash was that it tried to coordinate error trade
policies across trading venues to add certainty, so that market
participants would not have any doubt as to which trades would
stand and which might be cancelled.

On the way forward, in terms of technology:

In general, the FIA-PTG is very supportive of efforts to try to
improve the resiliency of trading infrastructure. Firms recognise
that a lot of these improvements are going to have to come from
the trading venue side, and the firms have been very supportive
of these efforts. It's clearly in the interest of all trading
firms to have a market infrastructure that they can depend on.

Firms have been working with regulators to promote
risk-mitigating ideas. Some of these ideas we saw implemented
after the Flash Crash. And new ideas have been advanced more
recently. In fact, the FIA recently released a guideline document
on drop copy functionality as a best practice control that may
help firms reconcile their trades in real time.

The FIA-PTG also put out a white paper on software change
management that identifies best practices on how to test trading
software at the firm level as a way to help regulators and
exchanges create testing environments and best practices for
software upgrades. Software testing is an important issue as - at
least in one instance - it was a contributor to trading glitch at
the exchange level.